Is there safety in structure when structures can change?

Investors in asset-backed securities have had a crash course in distressed scenarios over the past few years, beginning with, perhaps, the collapse of Heilig-Meyers in late 2000, the messy servicing transfer that followed and the ultimate disturbing recoveries to the once triple-A rated bonds.

According to investor sources, Heilig-Meyers senior noteholders have received just 70% of their principal investment, with the mezzanine and subordinate classes completely wiped out. This is believed to be the first and only ABS to date where the senior notes have suffered principal loss. From the look of things, however, there could be a few more.

Currently, the market is working through the hard reality of Conseco Finance's bankruptcy, where an unexpected ruling continues to impact the returns on more than $10 billion in outstanding manufactured housing bonds. Equipment bonds from DVI Inc., more recently a subject of the bankruptcy courts, will be closely watched.

What has been learned, however, is that in a seller/servicer bankruptcy, investors in senior classes have fared quite differently than those in the subordinate classes.

Though any shortfall in cash (either interest or principal) to the noteholders may be considered a technical default, this is not necessarily 100% reflective of the portfolio's underlying credit. For example, a servicer (or collector) recouping advances has led to interest shortfalls in the past, and have been considered defaults by some. Essentially, an asset-backed might continue paying up through the deal's maturity, though conclusive losses won't be known until the last payment passes through the trust.

When ABS turns junk

Ultimately, there are no rules in bankruptcy, as the potential is always there for the court to rule that the seller's assets were never legally sold, an event horizon somewhat like the securitization market's personal grim reaper. During the bankruptcy of LTV Steel in late 2000, these challenges were made, but never resolved (the DIP financer intervened and funded the assets out of question).

"There is a certain expediency in bankruptcy that is in tension with how things are usually done in one of the deals," said a bankruptcy attorney. "People may not realize when they go into a deal that [bankruptcy] is not a science but an art."

Unfortunately, in scenarios of distress, ultimate returns have been more closely tied to the solvency of the seller/servicer and the outcome of the bankruptcy court proceedings than the value of underlying collateral. This is troubling to an industry that places most of its weight on the legal isolation of assets. While legal isolation has yet to be fully tested, events and resolutions over the past two years have accentuated the performance linkage between a seller and its assets.

"People are still struggling with how to solve the connection between the servicer and pool performance, more so than they were a few years ago," said a partner at a law firm active in securitization. "What people are groping for is trying to make the servicing structure as strong as possible even if the transfer is held up for a couple of months."

While its difficult to draw generalities from ABS bankruptcies - as there's been so few of them - recent trends, or precedents, have emerged, some not so popular. Trustees seem to have disappointed many in the market. The trustee's role had come under serious fire during the aftermath of alleged fraud at National Century Financial Enterprises.

In Conseco/Green Tree, the bankruptcy court allowed a servicing fee restructuring as part of CFN Investment Holdings' purchase of Conseco's MH business and servicing platform. CFN succeeded in moving the servicing fees from the bottom to the top of the waterfall, and increasing the fee from 50 basis points to 150 basis points, with a scheduled 12-month step-down to 115 basis points. They were essentially

able to redirect and reprioritize excess spread, which reduced the credit enhancement in the deal.

Radian Asset Assurance said in January that it would likely pay claims of over $100 million tied to a 2000 vintage privately placed Conseco MH deal, as a direct result of the servicing fee reorganization.

Servicing fees are generally subordinated in the securitization waterfall, aligning the servicer's interests with the performance of the assets in the deal. The problem with Conseco, however, was that as it approached bankruptcy, its manufactured housing servicing platform had no prospects at profitability, making it a difficult asset to sell to a third party. It has been argued that resolution benefited the senior noteholders in Conseco MH, as it reintroduces an incentive for the servicer to perform its duties. Some of those at the bottom of the waterfall, however, are taking losses due to the disappearance of credit enhancement.

Some argue that the trustee, U.S. Bank, who was positioned as the backup servicer in the deal, should have taken over the servicing even if they were to suffer losses by doing so. The bottom line, according to industry participants, is that these provisions need to be set in stone in the documentation of the deal.

Late last year, the bankruptcy proceedings of DVI included a provision to increase the servicing incentive - in this case, the fee the servicer is paid to dispose of repossessed inventory - arguably at the expense of the deals' cashflow. One sources said this could cost the DVI deals several percentage points of cashflow.

"If I were a mezzanine bondholder in a situation where the servicer is an unrated entity, I would really be thinking about what would eventually happen if the company went bankrupt," the source said. "These bankruptcies rulings do raise serious questions about how different tranches are treated and who has the say."

Though different in detail than Conseco, both situations are examples of bondholders being "held hostage" by the trustee and/or the eventual servicer.

At different tiers

It has become most apparent that the different tiers of securities in a securitization may experience vastly different return profiles. In fact, in some cases, senior noteholders are walking away whole - albeit after costly and lengthy rounds of litigation. As seen in Heilig-Meyers, in some cases the mezzanine noteholders are wiped out completely.

In the case of NextCard, which entered into receivership with the Federal Deposit Insurance Corp. in 2002, the triple-A noteholders have been paid in full. The B class investors have yet to see losses, and are still being paid. Final repayment of the C class is still in question.

In most securitizations, an event of early amortization is structured into the deal, whereby, if trouble occurs, all payments pass through the trust as principal to repay to the senior-most class, until all classes are paid down. This inherently protects the seniors to the detriment of the subordinate noteholders. Often, while the seniors are being paid down, the servicing suffers, either because it is being transferred to a new party, or because the liquidity afforded the servicer by the securitization no longer exists.

In the case of Spiegel's First Consumers National Bank, the servicing fee was revised upward as mandated by the Office of the Comptroller of the Currency. The fee was increased from 2% to more than 8%, severely disrupting cashflow to the noteholders. Most expect the top class, at least, to suffer losses.

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